Capitalization vs Expensing | Top Differences| Examples

The key difference between Capitalization vs Expensing is that Capitalization is the method of recognizing the cost incurred as an expenditure which is capital in nature or recognizing such expenditure as an asset of the business, whereas, expensing refers to booking of the cost as an expense in the income statement of the business which is deducted from the total revenue while calculating the profits of the company.

Capitalization vs Expensing – Capitalization is defined as the recording of a cost like an asset, in spite of an expense. Such consideration is done while a cost not believed to be completely disbursed over the existing period instead, in a prolonged time period. Removing a key item from the company’s income statement while consecutively including it on firm’s balance sheet for just showing the depreciation as key charge contrary to profits, may lead to the expanding profits significantly.

Considering the telecom giant, WorldCom whose major portion of expenses comprised of operating expenditures referred to as the line costs. Such costs were remuneration offered to indigenous phone companies for using their phone lines. In general, line expenditures were treated normally like usual operating expenditures, however, it was assumed that a part of these expenses were real investments in undiscovered markets and are not expected to pay off for several years to come. This logic was employed by the company’s CFO, Scott Sullivan who started “capitalizing” his firm’s line costs during the latter part of the 1990’s. Therefore, these expenditures were removed from the company’s income statement, thereby increasing the profits by several billion dollars. Across Wall Street, it looked like WorldCom suddenly started delivering profits even in a downturn that was skipped by the industry experts until a major collapse that was witnessed later.

Worldcom declared bankruptcy in July 2002.

In this article, we discuss Capitalization vs Expensing and why it is very important for the financial analyst –

Capitalization vs Expensing?

Capitalization is the recording of an expense an asset. This is done when it is believed that the benefits of such expenses will be derived for an extended period of time. For instance, office goods are believed to get spent fast, thereby they are treated to be spent simultaneously. A vehicle is recorded like an immovable asset and expected to get spent over significantly long-time period via depreciation as the vehicle is expected to get consumed over a much longer time period compared to the office supplies.

Expensing is referred to as the assumption of any expenditure like an operating expense instead of as a capital investment. Considering taxation, an expense is reduced from income directly. Whereas an asset is depreciated or any business undertakes a series of reductions over the asset’s useful life.

Capitalization Example

If a company buys a car worth $50,000 in 2017. Now since the company has paid for this expense, should we take this expense ($50,000) in the Income statement of 2017 or should we record this expense as something else? You got it!

Let us assume that a car has a useful life of 10 years. This means that the company can derive the benefit of this car until the 10th year. Therefore it will not be wise to record all the expenditure at once in the Income Statement. We should capitalize on this expense of $50,000 and reduce it by the amount of value derived each year.

Therefore, we record the expense of $50,000 in the Asset at the beginning of 2017. During the year, we use $5000 worth of value, therefore the end of year Asset = $50,000 – $5000 = $45,000.

The above-discussed expense all through accounting is referred to as Depreciation.

Capitalization vs Expensing – Key Differences (Summary)

The major suggestion on a choice between expensing and capitalizing is while reporting profit every period. If one chooses to capitalize on any asset as against expensing it leads to greater profits while successively leading to greater taxes as well as improved business value. However, if we select expensing for any asset rather than its capitalization would deliver just opposite results.

Capitalization

Expensing

Cost recorded as an asset on the balance sheet

Cost recorded as operating expenditure on the income statement

While capitalizing any cost and later amortizing it results in the cost distributed over a longer time period

Under normal conditions, the complete expense is incurred while making any purchase

For asset capitalization, it should possess a valuable life that covers more than the existing year. These assets must be capable of running the entire business. However, any inventory being sold to customers doesn’t qualify to become a capital asset. Fixed assets are generally considered like equipment or a range of intangible assets like patents or copyrights. Usually, fixed assets ought to be depreciated as against being amortized.

While starting or purchasing a business, IRS enables one to remunerate the business beginning or procurement costs. The expenditures made to consume a patent, copyright, trademark or comparable rational property may be amortized. One may repay goodwill that is generally expected to be realized during sales owing to the ongoing usage of the reputation or name of any product or business that you intend to acquire. Generally, IRS allows one to repay geological expenditures that are intended to develop or locate petroleum wells all across the United States. One could even repay their research expenditures.

A General Rule: Any procurement beyond a specified dollar range is counted to be capital expenditure or capitalization

A General Rule: Purchasing lesser than the allocated dollar range is treated as an operating expenditure

As per accounting, upon an asset’s capitalization, it is assumed that the asset is still having economic value and it is believed to benefit prospective periods and thus is mentioned over a balance sheet.

An expense comprises of the core economic costs that are incurred by any business through daily operations for earning revenue. Every business is permitted to write-off all the tax-deductible expenditures on their specific returns for income taxes to minimize the taxable income, hence the tax liability. Most common business expenditures comprise of supplier payments, wages to employees, factory lease and depreciation of equipment.

Long Term Debt / Equity

Summary of the Adjustment after Capitalization of Expense

We note that most of the ratios have shown positive impact after capitalization

Capitalization vs Expensing – Effect on Financial Statements

The choice of capitalizing the costs would usually impact the firm’s financial statements. Some key areas involved while performing asset capitalization coupled with the way they may alter the firm’s financial statements include,

Balance Sheet Effect – Capitalization vs Expensing

The firm’s consolidated assets would grow upon capitalization of its costs.

The impact on shareholders’ equity would be negligible over the longer term, however, in the beginning, stockholder’s equity would be greater.

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Rationale for Expensing or Capitalization

While determining whether any cost must be either expensed or capitalized, firms often employ an easier technique of separating assets in two key segments,

Assets that deliver prospective gains

Assets that don’t deliver any prospective gains

Some of the firm’s costs would just deliver a one-time benefit for the firm and thus, comes under the second segment. These are usually expensed costs since the business is not believed to enjoy prospective gains through them.

Instead, assets that offer prospective gains may frequently stand capitalized and hence, the expenses would be distributed across financial statements.

An easy instance may be the payment of an insurance policy. The firm may purchase a fixed dated policy for say two years while paying the entire cost in one go. As the insurance would assist the firm in the near future also, it may capitalize on the expenditures.

Capitalization of Intangibles

Organizations may even come across intangible assets that are non-monetary properties and don’t have any physical matter however still deliver benefit for the company. Some examples of intangible assets include copyrights, patents or research and development expenditures.

Patents

Internally developed patents don’t show up in the Balance Sheet

SFAS 2 requires all costs incurred with the development of the patents be expensed as they are incurred

However, when one firm buys another firm, the total purchase price must be apportioned among the individual assets acquired

SFAS 2 requires that a portion of the purchase price be allocated to in-process R&D and be immediately written off

Managers have a strong incentive to allocate a large portion of the purchase price to purchased in-process R&D

Accounting for Software Development Costs

More liberal for accounting internal expenditures for software development

Software development cost is a major cost for many small, growth service companies and that’s their main asset

This prompted FASB to be more liberal while formulating SFAS 86

Limitations of Capitalization and Expensing

Capitalization

As the thumb rule for any asset capitalization is if that asset having long-term gain or value growth for the firm, there seem some drawbacks to this law. For instance, the research & development (R&D) costs are incapable of being capitalized, although such assets strictly offer long-term benefits to the company.

One key reason why most nations deny the capitalization of R&D expenditures is to overcome the doubt about the gains. Evaluating whether the prospective gains from an investment would be problematic and consequently, it is simpler to expense such costs.

However, local accountants in different countries may use different ways of analyzing R&D costs.

In addition, an asset’s capitalization may exaggerate the values of assets as depicted on the firm’s balance sheet that can influence the company’s financial statements to some extent.

Lastly, it is important to recollect that inventory costs can’t be capitalized. Even after one may be willing to hold that inventory over the long term and plans to sell it in the forthcoming business cycle, but expenses cannot be capitalized.

Expensing

While beginning a business, there are believed to be some key limitations regarding expensing. In several cases, instant costs may be capitalized despite they not essentially falling under the firm’s capitalization rules for the starting financial year.

One must also consider that as R&D costs are usually taken as an expense, some legal fees related to the asset’s acquisition coupled with the patent fees can be capitalized.

Furthermore, one must remain cautious while expensing costs related to upgrades or repairs. If an item’s value enhances notably or the item’s lifespan increases, the costs may better be capitalized.

Lastly, expensing lowers the business’s total income earned and hence, one must be cautious about ensuring that the near-term funds are capable of adjusting this modification.

Conclusion – Capitalization vs Expensing

Capitalization against expensing is believed to be a key aspect of any business’ financial policymaking. Costs may have a huge impact on the company’s business finances while it is crucial to acquire a capability to harness benefit from both capitalization and expensing.

The accounting management of expenditures can prove to be a key difference between any lucrative income statement and the one that illustrates a loss. It could be difficult to select from these options. However, at large, capitalization against expensing may offer the business with significant growth opportunities while keeping the company’s future bright.